ECB Preview: The End Of QE In A Time Of "Risks Tilted To The Downside"

On Thursday all eyes will be on the ECB monetary policy decision announced at 7:45am ET, with the press conference as usual 45 minutes later at 8:30am ET.

The ECB will leave all three key rates unchanged; Mario Draghi is expected to confirm the end of QE, announce next steps for reinvestment policy and a possible extension of the TLTRO. The ECB will likely signal that risks are tilted to the downside, but only do some tweaks on its growth and inflation forecasts. It is most likely that we get a reiteration of what we have heard so far with respects to how it conducts policy: flexible reinvestment policy using the capital key, and perhaps no decision on the TLTRO extension until March/April (which is being used as negotiating leverage with Italy's populist government). Traders will remain vigilant of any subtle changes that may impact the ECB forward guidance on rates and the pricing of a tightening cycle by markets.


PREVIOUS MEETING: October’s ECB policy announcement saw little in the way of fireworks after the central bank opted to maintain their current policy settings before unwinding their PSPP at the end of the year. Heading into the release, analysts speculated over whether recent developments in the Eurozone economy would force the hand of the governing council to suggest that risks surrounding growth are ‘tilted to the downside’. However, the Bank refrained from potentially disturbing markets before the conclusion of its QE programme and maintained its ‘broadly balanced’ viewpoint. Elsewhere, Draghi was quick to bat-away any questions on capital key recalculations, an extension to QE and what the Bank would do if the economic situation deteriorates by stating that they were not discussed.

ECB MINUTES: ECB Minutes stated members considered that the uncertainties related to global factors remained prominent, and the risks related to the external environment were assessed to be tilted to the downside. A remark was made about how the TLTRO maturity falling below 1yr could impact banks' liquidity position. Furthermore, policymakers generally agreed that data, while weaker than expected, remained consistent with expansion and gradually rising inflation pressures. Finally. It was emphasised that policy remained on steady track in line with market expectations and previous decisions.

SOURCE REPORTS: A bulk of the content of source reports has largely centred around the Bank’s reinvestment policy with sources at the end of November suggesting that policymakers are leaning towards only nuanced tweaks in its reinvestment policy, including an open-ended time horizon, and the Bank adopting a new capital key (revealed last week). In terms of the ECB’s normalisation efforts, sources last week suggested that the Bank is debating ideas for gradual stimulus withdrawal in 2019, with some policy makers in favour of hiking only deposit rate at first, whilst the door for TLTRO is said to be viewed as open.

ECB RHETORIC: During his speech at the European Parliament, ECB President Draghi highlighted that data that has become available since September has been somewhat weaker than expected, adding that the loss in growth momentum mainly reflects weaker trade growth, but also some country and sector-specific factors. Nonetheless, Draghi noted that the underlying strength of domestic demand and wages continues to support the ECB’s confidence that the sustained convergence of inflation to their aim will proceed. On the same day, ECB Chief Economist Praet stated that growth risks are balanced but the extremes in risk assessments are bigger than previous. Last week, ECB’s Vasilauskas opined that he does not expect surprises in growth projections at next week's policy meeting, but does see a degree of normalisation in the growth cycle.

DATA: In terms of recent data points for the EZ economy, growth metrics have been relatively disappointing with Q/Q growth in the Eurozone slipping to 0.2% in Q3 from the 0.4% seen in Q2 with analysts at Danske Bank suggesting that “early indications for Q4 GDP could suggest that the German car-related backlog will not disappear already in this quarter”. On the inflation front, recent declines in energy prices saw November headline inflation slip to 2.0% from 2.2%, with the super-core reading falling to 1.0% from 1.1%, albeit Goldman Sachs highlights that the core reading of 1.1% appears to be tracking in-line with ECB projections for 2018. In terms of soft data, the final Eurozone Composite PMI came in at 52.7 (Exp. 52.4) vs. the 53.1 seen in October with Danske highlighting that “industrial confidence and business climate have edged up slightly as well, which could be seen as the first sign of bottoming out of macro data in the coming months."


RATES: No adjustments expected on this front with any adjustments to rates guidance set to be more of a 2019 story. A few months ago, the next tweak to the ECB’s guidance on rates had been expected to be clarification on timings and the extent of moves. However, recent economic developments have caused markets to assign just a circa 75% of rate lift-off next year and thus, the next change in communication for the Bank might instead have to be pushing back the timeframe from their current “at least through the summer of 2019” level.

ASSET PURCHASES: Goldman Sachs expect the ECB will follow through with its current guidance and confirm the end of net asset purchases by year end. GS add that they “expect the ECB to continue to note that full reinvestments of its bond holdings will take place ‘for an extended period of time’ and in any case ‘for as long as necessary’”.

GROWTH/TRADE: Adjustments on this front heading into the previous meeting were a key source of focus and will continue to remain so this time around given recent economic developments. In October, the ECB stuck to it’s ‘broadly balanced’ assessment and Morgan Stanley expect them to do the same once again this week with the investment bank noting that although they “see downside risks to our [their] and the ECB numbers”, they conclude that “with QE set to be discontinued at year-end we [they] doubt that the central bank will overemphasise any particular downside skew in projections”. SocGen take an opposing view, suggesting that instead of making any adjustments to forward guidance on rates, the ECB will choose to provide some caution to the market by classifying risks as now ‘tilted to the downside’, thus giving the Bank more time to gather data at the beginning of 2019 before making any potential adjustments on their expected rate path. Interestingly, Goldman Sachs suggest that the ECB could opt for a compromise move by inserting a line stating that ‘risks are moving to the downside’.

INFLATION: Consensus is largely for the Bank to maintain current guidance on inflation with Morgan Stanley explaining that “the ECB will likely stay in a 'wait-and-see' mode, observing how underlying inflation performs in the coming months, before making any further shift to its communication, either to the dovish or hawkish side”.


Staff economic projections: Note, the December forecasts will see the inclusion of 2021 forecasts

Inflation: Given the recent pirce action in energy markets, the ECB are widely-touted to have to downgrade their oil price assumption that underpinned the September forecasts. With this in mind, Morgan Stanley believe that 2018 through 2020 inflation will have to be lowered to 1.6% before rising to 1.7% in 2021. Conversely, RBC think that the oil price assumption forecast by the ECB will miss some of the recent sell-off in energy markets given the cut-off date for the projections. As such, they argue that the impact of oil on inflation prospects will be relativley limited and offset by wage growth, which they believe will will need to be revised higher. Therefore, RBC expect 2019 and 2020 projections to remain unchanged and tout a potential upgrade for 2018 inflation (see box below)

Growth: On the growth front, given recent economic conditions in the Eurozone, the ECB are widely expected to make some downward revision of their GDP projections. In terms of the specifics, Goldman Sachs look for a 0.1pp downgraded to 2018 and 2019 growth citing the dissapointing Q3 outturn, lack of spare capacity and signs of slowing rowth from abroad. Elsewhere, ABN AMRO look for deeper eventual cuts of 0.1-0.2pp for 2018, 0.4pp for 2019 and 2020, albeit suggest that these downgrades will take place over the course of several meetings and thus done in stages. Morgan Stanley also look for across the board cuts with 2018 set to be lowered by 0.2pp with smaller 0.1pp cuts for 2019 and 2020 as lower oil prices softens the blow for the Eurozone economy.


In terms of other things to watch out for, any mention of TLTRO 3 will be a focus for markets amid speculation that the ECB could embark on another round of refinancing operations to help soothe the transition of policy normalisation and shield some of the more fragile Eurozone economies (particularly Italy) next year. SocGen argue the case for another round of TLTROs by stating “The euro area economy is currently fragile with high uncertainty and would need a boost to investment to support short-term growth and avoid medium-term bottlenecks in production”. However, in terms of the timing of a potential announcement, source reports last month stated that no decision on the TLTRO will be made at this meeting, instead, markets will be looking to Draghi for any signs over what discussions if (any) have been held thus far and how probable such an outcome is. In terms of a timeframe for a decision by the governing council, Goldman Sachs expect an announcement to be made at some point in H1 2019.


Elsewhere, the Bank’s approach to its reinvestment plan remains a key source of focus for market participants as the ECB’s PSPP draws to a close. Barclays outlines three key aspects of the policy that will ultimately need to be adressed by policymakers. 1) Reinvesment period: Barclays anticpated that the ECB will signal that “reinvestments will last for “two to three years and in any case for as long as needed”. 2) The average maturity profile of the portfolio: Barclays see “no solid case for maturity extensions yet given accommodative longer rates”. 3) Composition of reinvestment across assets and geographies: Barlcays “assume the ECB does not actively change the country composition of its APP programmes (to deliberately support weaker economies), or re-activate any programme (PSPP, CSPP, CBPP3 or ABSPP) to support any specific asset class”. In terms of other perspectives, Morgan Stanley suggest that the Bank will opt for a stance which sees its reinvestment policy linked to liquidity conditions and overall policy stance rather than any specific time horizon. Note, the ECB recently announced its 2019 capital key, however, there is currently a lack of specificity over whether this will be applied to future reinvestments and/or on the existing stock of purchases; clairty on this matter will likely be sought out during the press conference. That said, RBC caution that even if new purchases by the Bank shift towards the weighting stipulated by the 2019 capital key, the overall size of the Bank’s balance sheet (EUR 2trl) relative to the tweaks would mean that any such changes would be “so subtle as to not really matter for the market”.


see below for Danske Bank’s ECB scenario analysis chart: